Fifth Third Bank 2008 Annual Report Download - page 77

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fifth Third Bancorp 75
11. DERIVATIVES
The Bancorp maintains an overall risk management strategy that
incorporates the use of derivative instruments to reduce certain
risks related to interest rate, prepayment and foreign currency
volatility. Additionally, the Bancorp holds derivative instruments
for the benefit of its commercial customers. The Bancorp does
not enter into derivative instruments for speculative purposes.
The Bancorp’s interest rate risk management strategy
involves modifying the repricing characteristics of certain financial
instruments so that changes in interest rates do not adversely
affect the Bancorp’s net interest margin and cash flows.
Derivative instruments that the Bancorp may use as part of its
interest rate risk management strategy include interest rate swaps,
interest rate floors, interest rate caps, forward contracts, options
and swaptions. Interest rate swap contracts are exchanges of
interest payments, such as fixed-rate payments for floating-rate
payments, based on a common notional amount and maturity
date. Interest rate floors protect against declining rates, while
interest rate caps protect against rising interest rates. Forward
contracts are contracts in which the buyer agrees to purchase, and
the seller agrees to make delivery of, a specific financial
instrument at a predetermined price or yield. Options provide the
purchaser with the right, but not the obligation, to purchase or sell
a contracted item during a specified period at an agreed upon
price. Swaptions are financial instruments granting the owner the
right, but not the obligation, to enter into or cancel a swap.
Prepayment volatility arises mostly from changes in fair value
of the largely fixed-rate MSR portfolio, mortgage loans and
mortgage-backed securities. The Bancorp may enter into various
free-standing derivatives (principal-only swaps, swaptions, floors,
options and interest rate swaps) to economically hedge
prepayment volatility. Principal-only swaps are total return swaps
based on changes in the value of the underlying mortgage
principal-only trust.
Foreign currency volatility occurs as the Bancorp enters into
certain loans denominated in foreign currencies. Derivative
instruments that the Bancorp may use to economically hedge
these foreign denominated loans include foreign exchange swaps
and forward contracts.
The Bancorp also enters into derivative contracts (including
foreign exchange contracts, commodity contracts and interest rate
swaps, floors and caps) for the benefit of commercial customers.
The Bancorp may economically hedge significant exposures
related to these free-standing derivatives by entering into
offsetting third-party contracts with approved, reputable
counterparties with substantially matching terms and currencies.
Credit risk arises from the possible inability of counterparties to
meet the terms of their contracts. The Bancorp’s exposure is
limited to the replacement value of the contracts rather than the
notional, principal or contract amounts. The Bancorp minimizes
the credit risk through credit approvals, limits, counterparty
collateral and monitoring procedures. During 2008, credit
downgrades to certain counterparties of customer accommodation
derivative contracts negatively impacted their fair value by
approximately $31 million.
The Bancorp holds certain derivative instruments that qualify
for hedge accounting treatment under SFAS No. 133 and are
designated as fair value hedges or cash flow hedges. Derivative
instruments that do not qualify for hedge accounting treatment
under SFAS No. 133, or for which hedge accounting is not
established, are held as free-standing derivatives and provide the
Bancorp an economic hedge. All customer accommodation
derivatives are held as free-standing derivatives.
Fair Value Hedges
The Bancorp may enter into interest rate swaps to convert its
fixed-rate, long-term debt or time deposits to floating-rate.
Decisions to convert fixed-rate debt or time deposits to floating
are made primarily through consideration of the asset/liability mix
of the Bancorp, the desired asset/liability sensitivity and interest
rate levels. For the years ended December 31, 2008 and 2007,
certain interest rate swaps met the criteria required to qualify for
the shortcut method of accounting. Based on this shortcut
method of accounting treatment, no ineffectiveness is assumed.
For interest rate swaps that do not meet the shortcut
requirements, an assessment of hedge effectiveness was
performed and such swaps were accounted for using the “long-
haul” method. The long-haul method requires a quarterly
assessment of hedge effectiveness and measurement of
ineffectiveness. For interest rate swaps accounted for as a fair
value hedge using the long-haul method, ineffectiveness is the
difference between the changes in the fair value of the interest rate
swap and changes in fair value of the long-term debt attributable
to the risk being hedged. The ineffectiveness on interest rate
swaps hedging long-term debt or time deposits is reported within
interest expense in the Consolidated Statements of Income.
The following table reflects the change in fair value for
interest rate contracts and the related hedged items included in the
Consolidated Statements of Income.
For the year ended December 31, ($ in millions)
Consolidated Statements of
Income Caption 2008 2007
Interest rate contracts:
Change in fair value on interest rate swaps hedging long-term debt Interest on long-term debt ($776) 105
Change in fair value on long-term debt - hedged item Interest on long-term debt 765 (109)
Change in fair value on interest rate swaps hedging time deposits Interest on deposits (19) -
Change in fair value on time deposits - hedged item Interest on deposits 19 -
The following table reflects fair value hedges included in the Consolidated Balance Sheets as of December 31:
2008 2007
($ in millions)
Notional
Amount Fair Value
Notional
Amount Fair Value
Included in other assets:
Interest rate swaps related to debt $5,430 $823 3,000 67
Forward contracts related to mortgage loans held for sale -- 183 1
Total included in other assets $823 68
Included in other liabilities:
Interest rate swaps related to debt $ - $ - 775 21
Interest rate swaps related to time deposits 1,575 19 --
Forward contracts related to mortgage loans held for sale -- 511 4
Total included in other liabilities $19 25